THE IRREVOCABLE LIFE INSURANCE TRUST

As stated above, the IRS taxes all of the property that we transfer to others whether while we are still alive or at the time of our deaths; however, there are a few exceptions to this transfer tax. One such exemption is that under current tax laws every American citizen can transfer to others a certain amount of their property tax-free. The amount of property that you can transfer tax-free is known as the “exclusion” amount and is determined year to year by Congress. Congress also imposes progressively larger taxes on larger estates. These taxes can be as high as almost fifty percent of the estate. The addition of life insurance proceeds can, and often does, push estates not only above the exclusion amount but also from one tax bracket to the next. When this happens, the estate becomes subject to estate taxation simply because of the existence of the life insurance. The result is that a large portion of the life insurance goes to pay estate taxes instead of to the beneficiaries. Since the exclusion amount and the various tax brackets are frequently changed by Congress, you should see a qualified estate planning attorney to learn the current amounts and to determine if your life insurance is rendering your estate taxable.

Although owning life insurance can add to the tax burden on your estate, there is a solution to this problem. The solution is to place your life insurance into a special trust known as an Irrevocable Life Insurance Trust (ILIT).

An ILIT is similar to all trusts in that assets transferred to it are administered by a trustee who is required to follow the trust instructions. However, unlike revocable trusts that are usually established for the Trustmaker’s benefit and which can be amended by the Trustmaker at any time and for any reason, an ILIT is established for the benefit of someone other than the Trustmaker, usually the Trustmaker’s spouse or children. Furthermore, once created ILITs usually cannot be amended, at least not without the permission of a court of law. Neither of these limitations, though, is usually significant in light of the great planning opportunities available with an ILIT.

An ILIT accomplishes two objectives. First, it removes life insurance death proceeds from your estate and thereby reduces the value of your estate for estate tax purposes. Second, it allows you to direct how the proceeds of your life insurance will pass to your beneficiaries.

A brief example shows how an ILIT can prevent your life insurance from triggering unnecessary estate taxes. As stated earlier, if at the time of your death your property (including life insurance) exceeds the exclusion amount, your estate will have to pay estate taxes; however, if the life insurance is removed from your taxable estate by transferring it to an ILIT, the taxable value of your estate will decrease by the amount of the life insurance removed from it. The smaller your taxable estate the smaller your estate tax burden.

The best thing about ILITs is that they are specially designed to hold life insurance tax-free. The life insurance death proceeds will pass to your chosen beneficiaries estate tax-free because it was owned by the trust – not by you. It is that simple.

Does this sound too good to be true? It is not if the ILIT is properly drafted and implemented! In order to achieve this remarkable result, the ILIT must be drafted very carefully, the life insurance policies must be transferred to the ILIT in a specific manner, and the life insurance premiums must be paid in the correct fashion. Good advice from an experienced estate planning attorney is essential to making sure each of these detailed steps, and others, are done correctly.

One important detail in creating an ILIT is the selection of the trustee. Unlike revocable trusts where you can be your own trustee, you cannot be the trustee of your own ILIT. The IRS will treat the life insurance as if it is still in your own taxable estate because you will have too much personal control over it. Your spouse or adult child may be the trustee, but because of the technical requirements of ILITs, a better choice might be your accountant, other professional advisor, or a bank or trust company. The choice of your trustee should be given careful consideration.

Another important detail involving ILITs concerns the transfer of the life insurance policy to the trust. You can transfer either existing policies into your ILIT or you can have your trustee purchase a new life insurance policy on your life that is owned by the trust.

If you transfer an existing policy into an ILIT, there are two cautions. The transfer of an existing policy to an ILIT is treated under the tax code as a taxable gift, with the potential to trigger gift taxes. Whether or not the gift of an existing policy is taxable depends on the value of the policy and the amount of the current gift tax exemption. The other drawback of transferring an existing policy to an ILIT is that if you die within three years of the transfer, the IRS will consider the transfer invalid and the policy will be still included in your taxable estate.

These limitations make it preferable to purchase a new policy if you are still insurable. If a new policy is purchased, you will not have to be concerned with either determining an existing policy’s value for gift tax purposes or with the three-year transfer rule. Many clients are not concerned about the small statistical chance of dying within three years of the transfer. They consider the opportunity to save sometimes hundreds of thousands of dollars of their life insurance well worth the risk and the cost of establishing the ILIT.

When a new life insurance policy is transferred to an ILIT, the ILIT becomes responsible for paying the premiums necessary to keep it in force. The ILIT receives the funds needed to pay such premiums by accepting cash gifts from you or others. When these gifts are made, special care must be taken to ensure that no adverse federal gift taxes are incurred. It would be pointless to avoid estate taxes only to incur gift taxes. Careful planning is needed to simultaneously avoid both gift and estate taxes.

Questions frequently asked are, “Is it really necessary to go through all of the steps needed to create and transfer life insurance to an ILIT? Wouldn’t it simply be easier to remove the insurance from my taxable estate by gifting the policy to my spouse or another family member?” Although gifting a life insurance policy to someone else to remove it from your taxable estate is possible, there are a myriad of problems with someone else owning your policy.

First, when the policy is transferred to an individual, the same gift tax consequences must be considered that exist when transferring it to an ILIT. The steps taken in creating an ILIT make sure these gift tax issues are not overlooked.

Second, if a spouse or adult child owns a policy on your life, and he or she dies first, the policy’s value may cause an estate tax problem in his or her estate. Using an ILIT can significantly reduce or even eliminate the estate tax specter—not merely shift the tax burden from one person to another.

Third, when you transfer a life insurance policy to another person you lose all legal control over it. The new owner can change the beneficiary, take the cash value, or even cancel the insurance. Creating an ILIT where your chosen trustee is required to follow your instructions concerning use of trust assets can prevent this. A trustee will be responsible for paying premiums and is more likely to keep the policy in force than would a child or children when called upon to write a check for the premium.

Fourth, when insurance is transferred to individuals the beneficiaries usually receive the proceeds as an outright distribution at your death. Your family would lose all of the distribution protections that exist when life insurance is transferred to an ILIT. These protections include the following:

• If your children are underage they cannot accept ownership of any death benefits. If a minor child is named as a beneficiary of a life insurance policy, the insurance company will not pay the proceeds to the child. It will instead force the matter into probate court where the court will probably order the proceeds held in trust until the child’s eighteenth birthday. The child will then receive a cashier’s check for the remaining balance. This would not happen with an ILIT, which would allow you to maintain control over when and how children receive the proceeds;

• The death of a trust beneficiary will not result in the premature transfer of the policy to his or her spouse or minor child;

• Children may have asset protection from creditors, lawsuits, and divorcing spouses when life insurance is placed in an ILIT;

• An ILIT guarantees that the administrator of your estate will have liquidity needed to pay expenses and coordinate the administration of your estate;

• ILITs permit the use of generation-skipping transfers, a method used to pass unspent proceeds of the insurance from generation to generation without incurring taxes, that are not available with an outright distribution.

In summary, creating an ILIT that meets your objectives and fits into your overall estate plan requires careful planning and the assistance of an insurance professional and estate planning attorney. If properly established and implemented, it is an excellent way to help create an estate, protect an estate from unnecessary taxation, and most importantly, provide a lasting legacy for your loved ones.